Deposit creation

What Is Deposit Creation?

Deposit creation is the process by which commercial banks expand the money supply within an economy. This core concept in monetary policy describes how banks generate new deposits by extending loans, rather than simply acting as intermediaries for existing funds. It is a fundamental mechanism within the broader category of macroeconomics and is inextricably linked to the system of fractional reserve banking.

History and Origin

The concept of deposit creation emerged with the development of fractional reserve banking, a system whose roots can be traced back to ancient goldsmiths. These early custodians of precious metals would issue promissory notes for deposited gold. Over time, they realized that not all gold was withdrawn simultaneously, allowing them to lend out a portion of the deposited gold, thereby earning interest and essentially creating new money beyond the initial deposits.

In the modern era, the understanding of how banks create money through lending has been refined. The Bank of England, for instance, explicitly stated in a 2014 Quarterly Bulletin article titled "Money creation in the modern economy" that most money in circulation is created by commercial banks themselves when they make loans, not by the central bank's printing presses. This challenges some traditional economic textbooks that suggest banks merely lend out pre-existing deposits¹², ¹³, ¹⁴. The article highlights that "whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money"¹¹.

Key Takeaways

• Deposit creation is the process where commercial banks expand the money supply by extending new loans.
• It operates under a fractional reserve banking system, where banks hold only a fraction of deposits as reserves.
• The process is influenced by a bank's willingness to lend, borrower demand for credit, and the central bank's monetary policy.
• Deposit creation can stimulate economic growth by increasing available credit for investment and consumption.
• It is a significant factor in determining the overall level of money in an economy, impacting inflation and financial stability.

Formula and Calculation

The potential for deposit creation is often illustrated using the money multiplier formula, although it's important to note that this is a simplified model and does not fully capture the complexities of modern money creation. The formula for the simple money multiplier is:

Where:

• (M) = Money Multiplier
• (RR) = Reserve Requirement Ratio

This formula represents the maximum amount by which the money supply can expand for every unit of new reserves introduced into the banking system. For example, if a central bank injects new reserves into the banking system, and the reserve requirements are a certain percentage, the initial deposit can lead to a larger total increase in the money supply through successive rounds of lending and re-depositing.

Interpreting Deposit Creation

Deposit creation signifies the banking system's ability to influence the quantity of money available in an economy. When banks are actively engaged in deposit creation, it suggests a healthy demand for credit and a willingness of banks to lend, which can be a sign of robust economic activity. Conversely, a slowdown in deposit creation may indicate a credit crunch or decreased economic confidence. The extent of deposit creation is also a key indicator for central banks to gauge the effectiveness of their monetary policy tools, such as adjustments to interest rates or open market operations.

Hypothetical Example

Consider a scenario where the reserve requirement is 10%. A customer deposits $1,000 into Bank A.

1. Bank A is required to hold 10% of this deposit as reserves, which is $100.
2. The remaining $900 is considered excess reserves and can be lent out.
3. Bank A lends $900 to a borrower, who then uses this money to pay for goods or services.
4. The recipient of the $900 deposits it into their account at Bank B.
5. Bank B now has a new deposit of $900. It holds 10% ($90) as reserves and can lend out the remaining $810.
6. This process continues as the $810 is deposited into another bank, and so on.

The initial $1,000 deposit, through this process of deposit creation, can lead to a much larger increase in the total money supply. In this simplified model, the initial $1,000 could ultimately support up to $10,000 in new deposits (1 / 0.10 * $1,000 = $10,000).

Practical Applications

Deposit creation is a fundamental aspect of how monetary policy is implemented and affects the real economy.

• Monetary Policy Implementation: Central banks utilize tools like open market operations and setting interest rates to influence the reserves available to financial institutions, thereby indirectly controlling their capacity for deposit creation. For instance, when the Federal Reserve purchases securities in the open market, it injects money into the banking system, increasing bank reserves and potentially stimulating further lending and deposit creation. Conversely, selling securities reduces reserves, which can dampen deposit creation.
• Economic Stimulus: During periods of economic downturn, stimulating deposit creation through lower interest rates or programs like quantitative easing can encourage lending, investment, and consumption, aiming to boost economic activity. For example, following the 2008 financial crisis, the Federal Reserve undertook extensive quantitative easing to inject liquidity into the banking system and encourage lending¹⁰.
• Inflation Control: Excessive deposit creation without a corresponding increase in goods and services can lead to inflation as "too much money chases too few goods." Central banks often seek to manage deposit creation to maintain price stability.
• Financial Stability: Uncontrolled or reckless deposit creation, particularly through risky lending practices, can contribute to asset bubbles and financial instability. The financial crisis of 2008, for example, was partly fueled by a surge in mortgage lending and the securitization of these loans, which ultimately led to a significant contraction in interbank lending and a widespread credit crunch⁷, ⁸, ⁹.

Limitations and Criticisms

While deposit creation is a vital part of the modern financial system, it is not without limitations and criticisms.

One major critique is that the simplified money multiplier model, which assumes banks are always reserve-constrained, does not fully capture the complexities of how money is created in reality. Modern central banks and economists, including those at the Bank of England, assert that bank lending creates deposits, rather than banks simply lending out pre-existing deposits or being strictly limited by reserves⁵, ⁶. Instead, the availability of profitable lending opportunities and a bank's own risk management play a significant role.

Another limitation is that banks may not always choose to lend, even if they have ample reserves. During periods of economic uncertainty or a financial crisis, banks may hoard reserves or reduce lending due to concerns about borrower creditworthiness or their own balance sheets. This can lead to a credit crunch, where businesses and consumers struggle to access funds, hindering economic growth despite central bank efforts to inject liquidity³, ⁴. The Federal Reserve itself reduced reserve requirements to zero in March 2020, emphasizing that reserves are not the primary constraint on lending, but rather the demand for loans and banks' assessment of risk and profitability.

Deposit Creation vs. Money Multiplier

While closely related, deposit creation and the money multiplier represent different aspects of how money supply expands. Deposit creation is the actual process by which commercial banks generate new deposits when they extend loans. It describes the real-world action of a bank crediting a borrower's account, thereby increasing the total amount of money in the economy.

The money multiplier, on the other hand, is a theoretical concept, often presented as a formula, that illustrates the potential maximum expansion of the money supply based on an initial injection of reserves into a fractional reserve banking system. It suggests that a small increase in reserves can lead to a much larger increase in the money supply through a series of lending and re-depositing activities. However, the money multiplier is a simplification and does not account for factors such as banks choosing to hold excess reserves, a lack of demand for loans, or the influence of monetary policy tools beyond just reserve requirements. The reality of deposit creation is more dynamic and driven by a complex interplay of bank behavior, borrower demand, and central bank actions.

FAQs

How does a central bank influence deposit creation?

A central bank influences deposit creation primarily through monetary policy tools like setting interest rates (such as the federal funds rate target), conducting open market operations (buying or selling government securities), and, historically, by adjusting reserve requirements. These actions affect the amount of reserves in the banking system and the cost of borrowing for banks, which in turn influences their willingness and capacity to lend and thus create deposits.

Can deposit creation happen without new physical money being printed?

Yes, absolutely. Most deposit creation in the modern economy occurs digitally through ledger entries on bank balance sheets. When a commercial bank makes a loan, it simply credits the borrower's account with new funds, effectively creating new electronic money without the need for physical currency to be printed¹, ².

What happens if banks don't create enough deposits?

If banks don't create enough deposits, it can lead to a contraction in the money supply or a credit crunch. This can stifle economic growth as businesses and consumers find it harder to borrow money for investment and spending. A lack of sufficient deposit creation can exacerbate economic downturns and even lead to deflationary pressures.

Is deposit creation the same as printing money?

No, deposit creation by commercial banks is not the same as a central bank "printing money." While both processes increase the money supply, they operate differently. Central banks can physically print currency or create electronic reserves. Commercial banks, through deposit creation, generate new bank deposits by extending loans, which are liabilities on their balance sheets. This process does not involve printing physical currency, but rather increasing the digital money held by the public in bank accounts.

How does the public's behavior affect deposit creation?

The public's behavior significantly affects deposit creation. If individuals and businesses have a high demand for lending, banks will be more inclined to create deposits by extending loans. Conversely, if there's low demand for credit or a preference for holding cash rather than depositing it, the potential for deposit creation can be limited. Consumer and business confidence, investment opportunities, and overall economic sentiment all play a role in shaping this demand.